How Much Should a Firm Borrow? Principles of Corporate Finance Brealey and Myers Sixth Edition...
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Transcript of How Much Should a Firm Borrow? Principles of Corporate Finance Brealey and Myers Sixth Edition...
How Much Should a Firm Borrow?
Principles of Corporate FinanceBrealey and Myers Sixth Edition
Slides by
Matthew Will Chapter 18
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 2
Topics Covered
Corporate Taxes and Value Corporate and Personal Taxes Cost of Financial Distress Pecking Order of Financial Choices
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 3
Financial Risk - Risk to shareholders resulting from the use of debt.
Financial Leverage - Increase in the variability of shareholder returns that comes from the use of debt.
Interest Tax Shield- Tax savings resulting from deductibility of interest payments.
C.S. & Corporate Taxes
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 4
Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000.
Should you do this and why?
C.S. & Corporate Taxes
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000.
Should you do this and why?
All Equity 1/2 Debt
EBIT 1,000
Interest Pmt 0
Pretax Income 1,000
Taxes @ 40% 400
Net Cash Flow $600
C.S. & Corporate Taxes
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 6
All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Taxes @ 40% 400 360
Net Cash Flow $600 $540
Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000.
Should you do this and why?
C.S. & Corporate Taxes
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 7
C.S. & Corporate Taxes
All Equity 1/2 Debt
EBIT 1,000 1,000
Interest Pmt 0 100
Pretax Income 1,000 900
Taxes @ 40% 400 360
Net Cash Flow $600 $540
Total Cash Flow
All Equity = 600
*1/2 Debt = 640*1/2 Debt = 640
(540 + 100)
Example - You own all the equity of Space Babies Diaper Co.. The company has no debt. The company’s annual cash flow is $1,000, before interest and taxes. The corporate tax rate is 40%. You have the option to exchange 1/2 of your equity position for 10% bonds with a face value of $1,000.
Should you do this and why?
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 8
Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc
rD
= D x Tc
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 9
Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 10
Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 11
Capital Structure
PV of Tax Shield =
(assume perpetuity)
D x rD x Tc
rD
= D x Tc
Example:
Tax benefit = 1000 x (.10) x (.40) = $40
PV of 40 perpetuity = 40 / .10 = $400
PV Tax Shield = D x Tc = 1000 x .4 = $400
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 12
Capital StructureFirm Value =
Value of All Equity Firm + PV Tax Shield
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 13
Capital StructureFirm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Capital StructureFirm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Capital StructureFirm Value =
Value of All Equity Firm + PV Tax Shield
Example
All Equity Value = 600 / .10 = 6,000
PV Tax Shield = 400
Firm Value with 1/2 Debt = $6,400
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 16
C.S. & Taxes (Personal & Corp)
Relative Advantage Formula
( Debt vs Equity )
1-TP
(1-TPE) (1-TC)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 17
C.S. & Taxes (Personal & Corp)
Relative Advantage Formula
( Debt vs Equity )
1-TP
(1-TPE) (1-TC)
RAF > 1 Debt
RAF < 1 Equity
Advantage
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18- 18
Example 1All Debt All EquityIncome BTCP 1.00
less TC=.46 0.00
Income BTP 1.00
Taxes TP =.5 TPE=0 0.50
After Tax Income 0.50
C.S. & Taxes (Personal & Corp)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 19
Example 1All Debt All EquityIncome BTCP 1.00 1.00
less TC=.46 0.00 0.46
Income BTP 1.00 0.54
Taxes TP =.5 TPE=0 0.50 0.00
After Tax Income 0.50 0.54
C.S. & Taxes (Personal & Corp)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 20
Example 1All Debt All EquityIncome BTCP 1.00 1.00
less TC=.46 0.00 0.46
Income BTP 1.00 0.54
Taxes TP =.5 TPE=0 0.50 0.00
After Tax Income 0.50 0.54
RAF = .926 Advantage Equity
C.S. & Taxes (Personal & Corp)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 21
Example 2All Debt All EquityIncome BTCP 1.00
less TC=.34 0.00
Income BTP 1.00
Taxes TP =.28 TPE=.21 0.28
After Tax Income 0.72
C.S. & Taxes (Personal & Corp)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Example 2All Debt All EquityIncome BTCP 1.00 1.00
less TC=.34 0.00 0.34
Income BTP 1.00 0.66
Taxes TP =.28 TPE=.21 0.28 0.139
After Tax Income 0.72 0.521
C.S. & Taxes (Personal & Corp)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 23
Example 2All Debt All EquityIncome BTCP 1.00 1.00
less TC=.34 0.00 0.34
Income BTP 1.00 0.66
Taxes TP =.28 TPE=.21 0.28 0.139
After Tax Income 0.72 0.521
RAF = 1.381 Advantage Debt
C.S. & Taxes (Personal & Corp)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 24
Today’s RAF & Debt vs Equity preference.
Old Tax Code1-.28
(1-.28) (1-.34)= 1.52RAF =
C.S. & Taxes (Personal & Corp)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 25
Today’s RAF & Debt vs Equity preference.
New Tax Code1-.28
(1-.20) (1-.34)= 1.36RAF =
C.S. & Taxes (Personal & Corp)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Today’s RAF & Debt vs Equity preference.
1-.28
(1-.20) (1-.34)= 1.36RAF =
Why are companies not all debt?
C.S. & Taxes (Personal & Corp)
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 27
Capital Structure
Structure of Bond Yield Rates
D
E
Bond
Yield
r
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18- 28 Weighted Average Cost of Capitalwithout taxes (traditional view)
r
DV
rD
rE
Includes Bankruptcy Risk
WACC
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18- 29
Financial Distress
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
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18- 30
Financial Distress
Costs of Financial Distress - Costs arising from bankruptcy or distorted business decisions before bankruptcy.
Market Value = Value if all Equity Financed
+ PV Tax Shield
- PV Costs of Financial Distress
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 31
Financial Distress
Debt
Mar
ket V
alue
of
The
Fir
m
Value ofunlevered
firm
PV of interesttax shields
Costs offinancial distress
Value of levered firm
Optimal amount of debt
Maximum value of firm
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 32
Conflicts of Interest
Circular File Company has $50 of 1-year debt.
Circular File Company (Book Values)Net W.C. 20 50 Bonds outstandingFixed assets 80 50 Common stockTotal assets 100 100 Total liabilities
Circular File Company (Book Values)Net W.C. 20 50 Bonds outstandingFixed assets 80 50 Common stockTotal assets 100 100 Total liabilities
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Conflicts of Interest
Circular File Company has $50 of 1-year debt.
Why does the equity have any value ? Shareholders have an option -- they can obtain the
rights to the assets by paying off the $50 debt.
Circular File Company (Market Values)Net W.C. 20 25 Bonds outstandingFixed assets 10 5 Common stockTotal assets 30 30 Total liabilities
Circular File Company (Market Values)Net W.C. 20 25 Bonds outstandingFixed assets 10 5 Common stockTotal assets 30 30 Total liabilities
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 34
Conflicts of Interest
Circular File Company has may invest $10 as follows.
y)probabilit (90% $0
$10Invest
y)probabilit (10% $120
Next Year PayoffsPossibleNow
Assume the NPV of the project is (-$2). What is the effect on the market values?
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 35
Conflicts of Interest
Circular File Company value (post project)
Firm value falls by $2, but equity holder gains $3
Circular File Company (Market Values)Net W.C. 10 20 Bonds outstandingFixed assets 18 8 Common stockTotal assets 28 28 Total liabilities
Circular File Company (Market Values)Net W.C. 10 20 Bonds outstandingFixed assets 18 8 Common stockTotal assets 28 28 Total liabilities
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 36
Conflicts of Interest
Circular File Company value (assumes a safe project with NPV = $5)
While firm value rises, the lack of a high potential payoff for shareholders causes a decrease in equity value.
Circular File Company (Market Values)Net W.C. 20 33 Bonds outstandingFixed assets 25 12 Common stockTotal assets 45 45 Total liabilities
Circular File Company (Market Values)Net W.C. 20 33 Bonds outstandingFixed assets 25 12 Common stockTotal assets 45 45 Total liabilities
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
18- 37
Financial Distress Games
Cash In and Run
Playing for Time
Bait and Switch
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18- 38
Financial Choices
Trade-off Theory - Theory that capital structure is based on a trade-off between tax savings and distress costs of debt.
Pecking Order Theory - Theory stating that firms prefer to issue debt rather than equity if internal finance is insufficient.
©The McGraw-Hill Companies, Inc., 2000Irwin/McGraw Hill
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Trade Off Theory & Prices
1. Stock-for-debt Stock price
exchange offers falls
Debt-for-stock Stock price
exchange offers rises
2. Issuing common stock drives down stock prices; repurchase increases stock prices.
3. Issuing straight debt has a small negative impact.
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Issues and Stock Prices
Why do security issues affect stock price? The demand for a firm’s securities ought to be flat.
Any firm is a drop in the bucket.
Plenty of close substitutes.
Large debt issues don’t significantly depress the stock price.
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Pecking Order Theory
Consider the following story:
The announcement of a stock issue drives down the stock price because investors believe managers are more likely to issue when shares are overpriced.
Therefore firms prefer internal finance since funds can be raised without sending adverse signals.
If external finance is required, firms issue debt first and equity as a last resort.
The most profitable firms borrow less not because they have lower target debt ratios but because they don't need external finance.
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18- 42
Pecking Order Theory
Some Implications:
Internal equity may be better than external equity.
Financial slack is valuable.
If external capital is required, debt is better. (There is less room for difference in opinions about what debt is worth).